Outside Editorial: Fannie and Freddie were at heart of crisis

Much of the analysis of the housing crash and ensuing credit panic has focused on the manic activities of Wall Street, where most of the headlines of the debacle were made.

That’s a critical part of the story, but the recent lawsuit against six former top executives of Fannie Mae and Freddie Mac rightly moves the spotlight toward the government’s role in generating the crisis.

In the suit, the Securities and Exchange Commission accuses the executives — including former Fannie CEO Daniel Mudd and former Freddie CEO Richard Syron — of misleading the markets about their companies’ exposure to high-risk loans. As SEC Enforcement Director Robert Khuzami put it, “Fannie Mae and Freddie Mac executives told the world that their subprime exposure was substantially smaller than it really was,” giving analysts and rating agencies a skewed picture of the level of risk in the market.

Fannie and Freddie, odd hybrids, were at the heart of the crisis. Supposedly, they were private, stock-issuing corporations. But their government charter let them borrow at rates lower than competitors because markets assumed, rightly as it turned out, that if they failed the taxpayers would back them up. The “subprime exposure” mentioned by Khuzami was also taxpayer risk.

A bailout is exactly what happened in 2008. The government seized control of Fannie and Freddie and bailed them out at a cost, so far, of $150 billion.

Fannie and Freddie don’t make loans. They buy loans from those who do, and then keep them on their books or package them into bonds for sale to investors.

This was a great way to raise money to finance housing, but politicians pushed it too far. As Gretchen Morgenson of The New York Times and Joshua Rosner wrote in “Reckless Endangerment,” the Fannie-and-Freddie debacle shows what happens “when Washington decides, in its infinite wisdom, that every living breathing citizen should own a home.”

Beginning in 1992, the government began pushing for more allocation of credit to lower-income borrowers. To meet affordable-housing goals set by Congress, the two mortgage giants steadily lowered their credit standards and began buying subprime loans or no-document mortgages — those for which verification of key data like income was absent. Subprime originators seized the opportunity to reap profits with dubious mortgages while shifting the risk to Fannie and Freddie — and the Treasury.

Whenever concern was raised about the increased risk, reforms would be blocked by powerful Fannie-and-Freddie backers in Congress, like Massachusetts Rep. Barney Frank. “I want to roll the dice a little bit more in this situation toward subsidized housing,” Frank said in 2003. He argued that the same “safety and soundness” standards for banks shouldn’t apply to Fannie and Freddie. In Washington, he was hardly alone. Fannie and Freddie rewarded their friends well.

The SEC allegations against the former executives of Fannie and Freddie may well be tough to prove because of the lack of an agreed-upon legal definition of “subprime.” But it’s appropriate that more light shines on the role of the two mortgage giants, which did so much to encourage the subprime mania. As Charles W. Calomiris of the Columbia Business School wrote, “The decisions by Fannie and Freddie to embrace no-doc lending in 2004 opened the floodgates of bad credit.”

After that, loans to people with lousy credit or those offering little documentation exploded, rising to more than $1 trillion in 2006.

In some ways, Washington still hasn’t absorbed the lessons. The massive Dodd-Frank financial-reform bill did little to resolve the status of Fannie and Freddie — an issue that remains for the future.